Don’t fear the yield curve

What is it about us humans that attracts us to negative news and, especially, negative forecasts? It might be worries about our fragile existence, but whether it is this or some less cosmic cause we do love our doomsayers.

It isn’t a product of our times. In literature, for example, we have Shakespeare, who understood human nature as well as anyone, having Julius Caesar warned by a soothsayer to “beware the ides of March.” Earlier, of course, the Greeks had their Oracle at Delphi, where Pythia foretold the future. Delphic forecasts tended to be worded such that they would come true no matter what occurred — a tendency memorialized in our language as “oracular.”

While there are some similarities, oracular is too harsh a term for the “inverted yield curve” as an economic indicator. Rightly or wrongly, it did furnish the basis for the recent flurry of doomsaying and investor worries about a recession. But as a predictor, it is less than perfect.

A yield curve is a line graph that shows and compares market interest rates for short-term and long-term debt securities having the same credit risk but different maturities. While there are as many yield curves as there are debt securities, the yield curve most commonly referred to is for U.S. Treasury bonds.

A normal yield curve slopes upward; that is, the interest rate goes up as the maturity date gets farther and farther away from the present and the perceived risk rises. It’s called a yield curve because the interest rate shown on it is the effective interest rate, which takes into account the current market price paid for the bond — which may in fact be higher or lower than the original par value.

It’s called a curve because economists call almost all line graphs curves, even those that resemble or are straight lines. Real yield curves typically are curved, but occasionally are nearly straight. The theoretical, “normal” yield curve is straight and rises as the time to maturity increases.

Inverted yield curves slope downward and have preceded a lot of recessions but if it were a dependable indicator we would have shut down our economic research and forecasting efforts a long time ago. To start with, the negative yield curve as an indicator leaves out a couple of key pieces of information: time and intensity.

Throughout American history our economy has never been in equilibrium. It was and is always expanding or contracting. If the economy is expanding, then, it doesn’t take a genius or a fortune teller to say that a recession is coming. You will probably be right…eventually. And that is equally true if the economy is in recession and you predict that a recovery is coming. Right again, eventually.

An economy predictor that leaves out the “when” entirely or provides a wide block of time is of limited value, similar to predictions of the “big one” hitting California maybe tomorrow or maybe in 10,000 years.

The second thing left out is a measure of intensity. Just how negative is the yield curve? It would make sense that a steeply sloped negative yield curve would be a stronger indicator than one that was barely negative. But all negative yield curves are lumped together, usually, and many investment analysts reach for the alarm bell whenever the yield curve starts to flatten out.

The yield curve is all about investor expectations — for the economy and, more particularly, for the Fed’s monetary policy position. If investors believe that the Fed is going to raise interest rates to cool down the inflationary forces in the economy they will respond by shifting demand, which tends to flatten out the yield curve.

The yield curve itself does not present a threat to the U.S. economy, but it does reflect a change in bond investor expectations about Federal Reserve actions and about the durability of our current economic expansion, now just 12 months away from being the longest in history.

Much of our economy relies on debt, and the so-called “entitlement” sector of government spending is dependent on investors parting with cash to purchase trillions of dollars of the federal government’s debt. That means that the investor expectations reflected in the yield curve have some weight. However, it is good to remember that the negative yield curve may simply be the result of a delayed reaction of long-term interest rates to the economy’s expansion. If long-term rates were to rise, the inversion of the yield curve would disappear.

There are always a lot of things to worry about in our economy — short range and long range. The yield curve, however. isn’t one of them. It just shows that some other people are worried, too. It doesn’t mean that they are right.

James McCusker is a Bothell economist, educator and consultant.